Research Summary
The report introduces a new method to measure the residual interest rate risk exposure of financial intermediaries, specifically life insurers, using high-frequency financial market data. The method calculates the daily realized covariance of high-frequency stock returns and Treasury security returns to estimate the sensitivity of an individual firm’s stock price returns to changes in interest rates. The report applies this method to publicly-listed U.S. life insurers from 2007 to 2022 to assess their interest rate risk management.
Key Takeaways
Interest Rate Risk Management in Life Insurers
- Effective Hedging Strategies: The report finds that U.S. life insurers’ interest rate risk management strategies are generally effective, but they are more sensitive to changes in long-term interest rates compared to property and casualty insurers. The term premium helps explain the difference in sensitivities between life insurers and property and casualty insurers.
- Residual Interest Rate Risk Exposure: The measure of residual interest rate risk exposure reflects the effectiveness of financial intermediaries’ hedging strategies in relation to actual changes in interest rates. Monitoring residual interest rate risk exposures is important for analysts, policymakers, and supervisors to evaluate the financial conditions of financial intermediaries.
- Impact of Interest Rate Changes: A decrease in interest rates increases the present value of insurers’ fixed-rate liabilities faster than the present value of their fixed income assets, potentially leading to insolvency if not managed properly. Persistently low interest rates depress life insurers’ net investment spread on new business and force them to reinvest in bonds with lower coupon rates, further affecting their financial condition.
- Methodology and Application: The proposed method is applied to publicly-listed U.S. life insurers from 2007 to 2022 to assess their interest rate risk management. The empirical framework involves a regression model with two right-hand side variables, including Treasury security returns, to measure the residual interest rate risk exposure of financial intermediaries.
- Significance of Term Premium: The term premium, which compensates for the risk associated with holding longer-term bonds, helps explain the difference in sensitivities between life insurers and property and casualty insurers. The measure of term premium provides information about the impact of rapidly changing interest rates on insurers.
Actionable Insights
- Investigate the Potential of the Proposed Method: The proposed method to measure the residual interest rate risk exposure of financial intermediaries using high-frequency financial market data can be applied to other financial intermediaries for a comprehensive understanding of their risk management strategies.
- Consider the Impact of Term Premium: The term premium plays a significant role in explaining the difference in sensitivities between life insurers and property and casualty insurers. Therefore, it should be considered while evaluating the effectiveness of hedging strategies.
- Monitor Residual Interest Rate Risk Exposures: Regular monitoring of residual interest rate risk exposures is crucial for analysts, policymakers, and supervisors to evaluate the financial conditions of financial intermediaries and to take necessary actions.
- Assess the Impact of Interest Rate Changes: The impact of interest rate changes on the financial condition of life insurers should be assessed regularly. A decrease in interest rates can potentially lead to insolvency if not managed properly.
- Explore the Use of High-Frequency Financial Market Data: The use of high-frequency financial market data can provide valuable insights into the risk management strategies of financial intermediaries. Therefore, it should be explored further for a comprehensive understanding of the financial market.
